Dow Theory is a form of Technical Analysis derived from the works of Charles H. Dow, the founder of the wall street journal and Dow Jones Company (now most famously heard of in Dow Jones Industrial Average - The index of the 30 of the largest companies on the NYSE and acts as a benchmark for the world.)
- It has been around for about 100 years and has been proven to be succesful
- Dow theory is mainly comprised of different sections which all combine into one trend for the market.
- The market at any one time is in one of three modes - Primary, Secondary or intra-day.
- Primary represents the overall, longer trend which depending can last from many months, to years or even decades. This will either be a "bull" or "bear" market or when a market is rising in price or falling respectively.
- Once a trend has been established it is in effect until the trend changes, however the longevity of this move is hard - even impossible - to determine.
- Success, according to some is seen in identifying the primary trend and trading with it.
- These movements of the market are counter primary trend and move against the market for some time but are not changes just mere corrections.
- In a Bull market these can be sometime refereed to as a Correction in the market. Normally happens in overbought markets are investors sell to take profits.
- In a Bear market these short term correction are known as dead cat bounces and can simply can be caused by short covering.
- Some staticians have calculated that these secondary moves are about 50% of the orignial move and this could be calculated using Fibonacci retracements, but can spread between 33% - 66% of the move.
Intra-Day moves -
- These are daily flucuations in price that can be distacting from both primary and secondary trends. The daily movements should be taken into account but traders shouldn't jump to conclusions just because the market fell for one day.
- the only use of these is to group these smaller times into mini-primary and secondary moves to predict when we would continue with real trend.
Stages Of Primary markets:
- There are 3 stages in both Bull and Bear markets which are mainly pyschological state and the price action of the market.
- Primary Bull market - Accumulation:
- This stage is when there are a few investors who are seeing potential in stocks for the long run but the majority of the market is selling off and these traders are quietly building up large quantities of stock cheaply (Accumulation)
2. Primary Bull market - Big move or public participation:
- This stage is when the general market catches on and the market starts to bottom out, Shorts will cover and the market will start to rise and the general population gets more "bullish" on the outlook with good economic data being released.
3. Primary Bull Market - Excess:
- This is where the the price is rising at almost a parabolic rate and there is excessive price rise with even the population buying stocks with earnings coming out so good, A saying is born from this on wall street "when the Taxi cab driver begin to offer tips; the top cannot be far off."
- Primary Bear Market - distribution:
- This is where some investors are selling off their exposure to the markets in anticipation of a large sell-off, this calms down market rises and but fears of a turn around are becoming more frequent.
2. Primary Bear Market - Big move:
- Trend has turned and this could be time to think about selling, Many people fear a bear market is forming with prices steadily falling.
3. Primary Bear Market - Despair:
- there are franktic selling with stocks crashing and sellers just selling, this is like 2008 with Global stock markets.
Markets discount all fundamentals:
- This is the fact that when an economic release comes out the market almost instantly factors in the difference with a new price. This makes trading fundamental through dow theory ostly redundant.
Trends are Confirmed by Volume:
- This is the rule that Bullish volume is associated with bullish price and vice versa.
- This means that when prices are rising the volume trade should rise (this is seen in further detail in my other article http://tinyurl.com/7wjwwr3
- This also means falling prices should be seen with falling volume
- There is a problem with forex as there is no set volume but every other market is ok, such as stock, futures, commodities.
Stock Market Averages confirm each other:
- Back in the day the "rail" industry was seen as a market that must correlate with the industrials and so the overall market cannot rally without the railway companies profiting by the increase in demand throughut the economy.
- However some nowadays use the airlines as they are very susebtible to economic changes and are very cyclical , and the average PE ratio is merely 10 as opposed to 28 in SP500.
- This can be easily converted to the Forex Market with the Highly Correlated pairs Such as AUDUSD and NZDUSD, where they both set-up for profitable runs but could also be seen that one doesn't confirm the other and then the dow theory doesn't work and so Could be a false move in the underlying pair.
- Here is an example of where EURUSD -Doesn't- break out of a trendline where as the highly correlated pair AUDUSD has broken out. As they are both driven by broad risk the AUDUSD may not breaak out and could fall in co-ordination with EURUSD.
Trends Exist until broken.
- This is the most vague section as it is unclear to when a trend is broken or not, but the underlying message is that minor movements are just noise and shouldn't make you scared and you should hold strong with your position.
Well that all sums up a comparatively ancient form of Technical Anaylsis but these ideas can be easily translated onot any time frame from yearly, to secondly.
Hope this helps, Thanks.